Zeal: Major Stock Selloff Looms

by Adam Hamilton, Silver Doctors Though you wouldn’t know it from recent history, stock markets rise and fall. They are forever cyclical, an endless parade of alternating bulls and bears. Market history simply couldn’t be clearer on this. Yet ironically after long bull or bear markets, the great majority of traders forget this. They get caught up in their own emotions, and wrongly assume the long-in-the-tooth trend is the new norm that will endure perpetually. That perfectly describes American stock traders’ worldview today. After one of the biggest cyclical bull markets in history, a huge 213% march higher over 6 years in the flagship S&P 500 stock index, investors and speculators alike fully believe this bull has years left to run yet. They cavalierly dismiss even the mere possibility of a serious selloff, hubristically assuming fundamentals, technicals, and sentiment no longer matter. But they always do, this time is never different. After running too far for too long, stock markets always reverse. It’s as inevitable as winter following summer, or night following day. The greed and fear that dominate traders’ hearts never change, and as long as these warring emotions reign there will always be stock-market cycles. And given today’s stock-market extremes, there’s no doubt a trend change is long overdue. Fundamentally, the S&P 500 (SPX) is trading at an exceedingly-expensive 25.9x earnings! That is the simple average of all 500 elite SPX component stocks’ trailing-twelve-month price-to-earnings ratios. Historical fair value is 14x, while 28x is bubble territory. Study any broad swath of stock-market history, and it quickly becomes apparent that buying expensive stocks high soon guarantees serious losses. Wall Street is so afraid of investors learning how expensive stocks are today that it is aggressively trying to mask valuations by using fictional forward earnings. These are merely analysts’ guesses about the future profits of companies, something they are forever excessively optimistic on. Provocatively, stocks are so overvalued today that they are even very expensive on that forward basis! This is super-ominous. Meanwhile after more than tripling in the past 6 years, the SPX is radically overextended technically. We are now in one of the longest cyclical bulls in history. Interestingly if you crunch the numbers, average bull markets at this stage in the stock-market cycles end at merely a doubling in less than 3 years. Like a rubber band stretched farther and farther, the bigger and older a bull the higher the odds it’s soon going to fail. It’s been a dumbfounding 41 months since the end of the SPX’s last correction, a selloff that exceeds 10%. On average in healthy bull markets, they happen about once a year or so. These extremes are the direct product of the Fed’s wildly unprecedented open-ended QE3 debt-monetization campaign and its associated jawboning. The Fed implied it was backstopping stock markets, so traders threw caution to the wind. And on top of these grave fundamental and technical concerns, traders’ sentiment is epically bullish. They are euphoric, feeling great happiness at today’s stock-market levels. They are complacent, very satisfied with the current situation and smugly unconcerned it will ever change. And they are hubristic, arrogant and proud in their overwhelming bullishness. All this adds up to totally unsustainable greed. The endless war between popular greed and fear among stock traders is like a giant pendulum. When their emotions get too extreme on either end of that spectrum, the too-high pendulum soon slows and reverses and starts swinging the other way. The more extreme the emotion, the greater the momentum in that backswing to the opposite extreme. So exceptional greed is always followed by exceptional fear. While there’s no way to empirically measure emotions, many great tools have arisen over the decades that approximate them. The leading one is the VIX, the CBOE’s Market Volatility Index. It measures the implied volatility of S&P 500 index options over the coming month. The higher the volatility implied in speculators’ aggregate bets, the greater the fear. This works because greed and fear are very asymmetrical. Greed grows gradually, slowly mounting as stock markets climb on balance for years. Traders want to buy stocks, but aren’t in any hurry as a herd to do so. But fear is just the opposite, a sudden and flaring emotion that demands fast action. The more greedy traders are, the lower the VIX because they expect the stock markets to rally forever. The more fearful they are, the higher the VIX as they rush to sell and flee. This first chart looks at this VIX fear gauge with the dominant S&P 500 ETF, State Street’s SPDR that trades under the symbol SPY. During the Fed’s extraordinary SPX levitation of the past couple years, the stock markets rallied with only minor pullbacks from time to time. This unnatural behavior has left complacency extremely high as measured by the VIX. A low VIX is usually a warning of an imminent selloff. Zeal030615A Stock-market selloffs are categorized by size. Anything under 4% on the SPX or SPY doesn’t have a name, it’s just normal market noise. From 4% to 10%, selloffs become pullbacks. There have been 7 of these since the Fed’s surreal stock-market levitation got underway with QE3 in late 2012. But most were on the small side, which means they did little to accomplish selloffs’ primary mission of rebalancing sentiment. Between 10% to 20%, selloffs grow into corrections. These major selloffs are actually very important for the health of bull markets. They serve to quickly ramp fear, which rapidly bleeds away excessive greed and complacency. Restoring sentiment balance keeps stock markets from getting too overheated, which happens if they rally for too long without corrections. There hasn’t been a single one during the Fed’s levitation! Not only was QE3 massive and open-ended, but Fed officials fell all over themselves successfully trying to convince stock traders that the Fed was effectively backstopping the stock markets. They implied that if any major selloff happened, the Fed would be quick to ramp its money printing to arrest the weakness. So stock traders bought and bought, growing ever greedier as they ignored all risks and historical indicators. The problem is excessive greed sucks future buying forward. Investors who would’ve bought in later in normal market conditions grow excited and plow all their capital in earlier to chase the gains. This leads to a temporary surge, but it soon runs out of steam. Once everyone interested in buying stocks anytime soon is in, there are no more buyers. So starved for new capital inflows, the lofty stock markets soon start reversing. But the Fed went even farther than that during QE3. Not only did its excessively-easy stance convince stock traders to buy high, but QE3’s debt monetizations decimated yields in the bond markets. This forced investors who would prefer bonds at normal fair yields to begrudgingly migrate into far-riskier stocks to chase reasonable returns through dividends. The result is SPY’s incredible 56.2% surge in just 27.5 months! Continue Reading>>>

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